The Theory of

Consumer Choice
CHAPTER 21
In this chapter,
look for the answers to these questions:
• How does the budget constraint represent the choices a
consumer can afford?
• How do indifference curves represent the consumer’s
preferences?
• What determines how a consumer divides her resources
between two goods?
• How does the theory of consumer choice explain
decisions such as how much a consumer saves,
or how much labor she supplies?

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 Introduction
• Recall one of the Ten Principles from Chapter 1:
People face tradeoffs.
– Buying more of one good leaves
less income to buy other goods.
– Working more hours means more income and more
consumption, but less leisure time.
– Reducing saving allows more consumption today but
reduces future consumption.
• This chapter explores how consumers make choices
like these.
THE THEORY OF CONSUMER
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CHOICE
 The Budget Constraint:
What the Consumer Can Afford
• Example:
Hurley divides his income between two goods:
fish and mangos.
• A “consumption bundle” is a particular combination of
the goods, e.g., 40 fish & 300 mangos.
• Budget constraint: the limit on the consumption
bundles that a consumer can afford

THE THEORY OF CONSUMER

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CHOICE
ACTIVE LEARNING 1
Budget Constraint
Hurley’s income: $1200
Prices: PF = $4 per fish, PM = $1 per mango
A. If Hurley spends all his income on fish,
how many fish does he buy?
B. If Hurley spends all his income on mangos,
how many mangos does he buy?
C. If Hurley buys 100 fish, how many mangos can he
buy?
D. Plot each of the bundles from parts A – C on a
graph that measures fish on the horizontal axis and
mangos on the vertical, connect the dots. 5
ACTIVE LEARNING 1
Answers D. Hurley’s budget
Quantity of
Mangos constraint shows the
B bundles he can
A. $1200/$4 afford.
= 300 fish
B. $1200/$1 C
= 1200
mangos
C. 100 fish cost
$400,
$800 left
buys 800 A
mangos Quantity
of Fish
 The Slope of the Budget Constraint

The slope of the budget constraint equals

– the rate at which Hurley
can trade mangos for fish
– the opportunity cost of fish in terms of mangos
– the relative price of fish:

THE THEORY OF CONSUMER

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CHOICE
ACTIVE LEARNING 2
Budget constraint, continued.
Show what happens to Hurley’s budget constraint if:
A. His income falls to $800.
B. The price of mangos rises to
PM = $2 per mango

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ACTIVE LEARNING 2
Answers, part A
Quantity of A fall in income
Now, Mangos shifts the budget
Hurley constraint down.
can buy
$800/$4
= 200 fish
or
$800/$1
= 800 mangos
or any
combination in
between.
Quantity
of Fish
ACTIVE LEARNING 2
Answers, part B
Quantity of An increase in the
Hurley Mangos price of one good
can still buy
pivots the budget
300 fish.
constraint inward.
But now he
can only buy
$1200/$2 =
600 mangos.
Notice:
slope is smaller,
relative price of
fish is now only 2
mangos. Quantity
of Fish
 Preferences: What the Consumer Wants

Indifference curve: Quantity One of Hurley’s

of Mangos indifference curves
shows consumption
bundles that give the
consumer the same
level of satisfaction
B
A, B, and all other
bundles on I1 make A
Hurley equally happy – I1
he is indifferent between
them.
Quantity
of Fish
THE THEORY OF CONSUMER
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CHOICE
 Four Properties of Indifference Curves

Quantity One of Hurley’s

1. Indifference curves of Mangos indifference curves
are downward-
sloping.

If the quantity of
B
fish is reduced,
the quantity of A
mangos must be
I1
increased to keep
Hurley equally happy.
Quantity
of Fish
THE THEORY OF CONSUMER
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 Four Properties of Indifference Curves

Quantity A few of Hurley’s

2. Higher indifference of Mangos indifference curves
curves are preferred
to lower ones.

Hurley prefers every

bundle on I2 (like C) C
D
to every bundle on I1 A I2
(like A). I1
He prefers every bundle
on I1 (like A) I0
to every bundle on I0 Quantity
of Fish
(like D).
THE THEORY OF CONSUMER
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 Four Properties of Indifference Curves

Quantity Hurley’s indifference

3. Indifference curves of Mangos curves
cannot cross.
Suppose they did.
Hurley should prefer
B to C, since B has B
more of both goods.
Yet, Hurley is indifferent C A
between B and C: I1 I4
He likes C as much as A
(both are on I4).
Quantity
He likes A as much as B of Fish
(both are on I1).
THE THEORY OF CONSUMER
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CHOICE
 Four Properties of Indifference Curves

Quantity
4. Indifference curves of Mangos
are bowed inward.
A
Hurley is willing to give
up more mangos for a 6
fish if he has few fish (A)
1
than if he has many (B).
B
2
1 I1

Quantity
of Fish
THE THEORY OF CONSUMER
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 The Marginal Rate of Substitution

Marginal rate of Quantity MRS = slope of

substitution (MRS):
of Mangos indifference curve
the rate at which a consumer
is willing to trade one good for A
another.
MRS = 6
Hurley’s MRS is the
amount of mangos he 1
would substitute for B
MRS = 2
another fish. 1 I1
MRS falls as you move down
along an indifference curve. Quantity
of Fish
THE THEORY OF CONSUMER
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 One Extreme Case: Perfect Substitutes
Perfect substitutes: two goods with straight-
line indifference curves,
constant MRS
Example: nickels & dimes
Consumer is always willing to trade
two nickels for one dime.

THE THEORY OF CONSUMER

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CHOICE
Another Extreme Case: Perfect Complements
Perfect complements: two goods with
right-angle indifference curves
Example: Left shoes, right shoes
{7 left shoes, 5 right shoes}
is just as good as
{5 left shoes, 5 right shoes}

THE THEORY OF CONSUMER

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 Less Extreme Cases:
Close Substitutes and Close Complements

Quantity Indifference Quantity Indifference

of Pepsi curves for close of hot dog curves for
buns
substitutes are close
not very bowed complements
are very bowed

Quantity Quantity
of Coke of hot dogs
Optimization: What the Consumer Chooses
A is the optimum: Quantity
of Mangos
The optimum
the point on the
is the bundle
budget constraint
Hurley most
that touches the
1200 prefers out of all
highest possible
the bundles he
indifference curve.
can afford.
Hurley prefers B to A, B
but he cannot afford B. 600
A

Hurley can afford C C

and D, D
but A is on a higher
indifference curve. 150 300 Quantity
THE THEORY OF CONSUMER of Fish
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CHOICE
Optimization: What the Consumer Chooses
Quantity
At the optimum, of Mangos Consumer
slope of the optimization is
indifference curve another example of
equals 1200 “thinking at the
slope of the budget margin.”
constraint:
MRS = PF/PM A
600

marginal
price of fish
value of fish
(in terms of
(in terms of
mangos)
mangos) 150 300 Quantity
THE THEORY OF CONSUMER of Fish
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 The Effects of an Increase in Income
Quantity
of Mangos
An increase in
income shifts the
budget constraint
outward.
B
If both goods are A
“normal,” Hurley
buys more of each.

Quantity
THE THEORY OF CONSUMER of Fish
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CHOICE
ACTIVE LEARNING 3
Inferior vs. normal goods
• An increase in income increases the quantity
demanded of normal goods and reduces the
quantity demanded of inferior goods.
• Suppose fish is a normal good
but mangos are an inferior good.
• Use a diagram to show the effects of
an increase in income on Hurley’s optimal
bundle of fish and mangos.

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ACTIVE LEARNING 3
Answers Quantity
of Mangos

If mangos are
inferior, the new
optimum will contain
fewer mangos.

A
B

Quantity
of Fish
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 The Effects of a Price Change
Quantity
Initially,
of Mangos
PF = $4
1200
PM = $1 initial
optimum

PF falls to $2 new
optimum
budget constraint 600
500
rotates outward,
Hurley buys
more fish and
fewer mangos.
150 300 600 Quantity
350 of Fish

THE THEORY OF CONSUMER

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CHOICE
 The Income and Substitution Effects
A fall in the price of fish has two effects on
Hurley’s optimal consumption of both goods.
– Income effect
A fall in PF boosts the purchasing power of Hurley’s
income, allows him to buy more mangos and more fish.
– Substitution effect
A fall in PF makes mangos more expensive relative to fish,
causes Hurley to buy fewer mangos & more fish.
Notice: The net effect on mangos is ambiguous.

THE THEORY OF CONSUMER

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 The Income and Substitution Effects
Initial Quantity
In this example,
optimum at A. of Mangos
the net effect on
PF falls. mangos is
negative.
Substitution effect:
from A to B,
buy more fish and A
fewer mangos. C

Income effect: B
from B to C,
buy more of both
goods. Quantity
of Fish
THE THEORY OF CONSUMER
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 CONCLUSION:
Do People Really Think This Way?
• People do not make spending decisions
by writing down their budget constraints and
indifference curves.
• Yet, they try to make the choices that maximize their
satisfaction given their limited resources.
• The theory in this chapter is only intended as a
metaphor for how consumers make decisions.
• It explains consumer behavior fairly well in many
situations and provides the basis for more advanced
economic analysis.

THE THEORY OF CONSUMER

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CHOICE
CHAPTER SUMMARY

• A consumer’s budget constraint shows the possible

combinations of different goods she can buy given her
income and the prices of the goods. The slope of the
budget constraint equals the relative price of the
goods.
• An increase in income shifts the budget constraint
outward. A change in the price of one of the goods
pivots the budget constraint.

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CHAPTER SUMMARY

• A consumer’s indifference curves represent her

preferences. An indifference curve shows all the
bundles that give the consumer a certain level of
happiness. The consumer prefers points on higher
indifference curves to points on lower ones.
• The slope of an indifference curve at any point is the
marginal rate of substitution – the rate at which the
consumer is willing to trade one good for the other.

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CHAPTER SUMMARY

• The consumer optimizes by choosing the point on her

budget constraint that lies on the highest indifference
curve. At this point, the marginal rate of substitution
equals the relative price of the two goods.
• When the price of a good falls, the impact on the
consumer’s choices can be broken down into two
effects, an income effect and a substitution effect.

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CHAPTER SUMMARY

• The income effect is the change in

consumption that arises because a lower price
makes the consumer better off. It is
represented by a movement from a lower
indifference curve to a higher one.
• The substitution effect is the change that
arises because a price change encourages
greater consumption of the good that has
become relatively cheaper. It is represented
by a movement along an indifference curve.
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CHAPTER SUMMARY

• The theory of consumer choice can be applied in many

situations. It can explain why demand curves can
potentially slope upward, why higher wages could
either increase or decrease labor supply, and why
higher interest rates could either increase or decrease
saving.

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